Net Unrealized Appreciation and the Opportunity You Might be Missing
KEY TAKEAWAYS:
- Employees may be able to pay tax at the long-term capital gains rate rather than the ordinary income rate on employer stock distributed from a company retirement plan.
- To qualify for preferential tax treatment, the employee must withdraw the entire balance of the retirement plan within one calendar year and transfer the full or partial balance of the stock directly into an investment account.
- This technique is most advantageous for company stock with low basis.
Net unrealized appreciation (NUA) is appreciation (fair market value minus cost basis) of employer stock held within a company retirement plan. There is a tax planning technique available to defer taxation of the NUA when the stock is distributed from a retirement plan and tax the gain upon sale as a capital gain. Normally, all distributions from a retirement plan are taxed as ordinary income, so this technique could provide a significant tax break.
A company retirement plan may be a 401(k), pension, profit sharing or ESOP. The stock receiving the treatment must be the stock of the employer that is administering the plan. The stock must be distributed in kind (e.g., not sold) and transferred into an investment account to achieve the desired tax treatment. When the stock is distributed from the retirement plan, the employee will pay ordinary income tax on the cost basis of the stock. NUA gain is not subject to the 3.8% Medicare surtax. This technique is most advantageous for employer stock with low basis. It is important to make sure your tax preparer and investment advisor know you are utilizing the NUA strategy.
An employee has the option of distributing the stock from their plan at the following triggering events:
- Reaching age 59 ½ (if the plan allows in-service distributions).
- Separation of service. (If under 55, a 10% early withdrawal penalty may apply to the cost basis of the stock).
- Disability (if self-employed).
- Death.
The employer stock being distributed from the plan must be part of a lump sum distribution, meaning the entire balance of the plan must be distributed within one calendar year. Some or all of the distribution may be rolled over into an individual retirement account or IRA to defer taxation. However, the employer stock cannot be rolled over into an IRA or another retirement plan if NUA treatment is being elected. The NUA stock must be transferred to an investment account.
Examples: Mary is 65 and is retiring from her company. She has $500,000 in her 401(k), out of which $100,000 is company stock with a cost basis of $10,000.
- Scenario 1: Mary can roll the entire balance into an IRA and recognize ordinary income as she takes distributions.
- Scenario 2: Mary can distribute the stock into an investment account and roll the remaining balance into an IRA. She will pay ordinary income on the $10,000 cost basis of the stock when she puts it in the investment account. If she sells the stock immediately, the $90,000 will be taxed as long-term capital gains.
- Scenario 3: Mary can distribute the stock into an investment account and roll the remaining balance into an IRA. She will pay ordinary income on the $10,000 cost basis of the stock. If she waits to sell the stock when the fair market value is $110,000 five months later, $90,000 will be considered long-term capital gains and $10,000 will be short-term capital gains.
Disqualifications for NUA treatment:
- Rolling the stock from a company plan into an IRA or other retirement plan.
- Taking distributions from a company plan in a year prior to executing a NUA (i.e., Required Minimum Distributions).
NUA treatment can be very valuable to employees with highly appreciated company stock in employer sponsored plans. Please consult your CPA for tax guidance to ensure you have met all the requirements and the transaction is accounted for appropriately on your tax return.
